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International Portfolio

Investment

Reading: Chapter 15
2
Lecture Outline
Basics of diversification
Benefits of international diversification
Measuring foreign investment performance
The home bias puzzle

3
Why Go Global?
In a nutshell: Diversification!!!
Potential for higher expected returns for same risk.
Potential for lower portfolio risk for same return.

Standard deviation of return
Expected return
Domestic investing
International investing
4
International Correlations & Diversification
Security returns are much less correlated across
countries than within a country.
This is because economic, political, institutional and even
psychological factors affecting security returns tend to vary
across countries, resulting in low correlations among
international securities.
Types of companies in each country can also vary
significantly.




5
International Stock Returns (70 04)
Mean
(%)
Std. Dev.
(%)
Std. Dev.
(%, LC)

W
(1970-2004)
Australia 12.33 24.03 10.98 1.005
France 12.62 21.02 21.04 1.042
Germany 8.91 23.39 28.36 0.950
Japan 5.14 24.40 16.78 1.017
Netherlands 13.45 17.97 22.33 0.974
Switzerland 12.96 17.90 15.78 0.879
UK 11.94 17.73 15.54 1.065
USA 12.22 15.86 16.44 0.920
6
International Correlation Structure (70 04)

Stock Market

AU

FR

GM

J P

NL

SW

UK

US

Australia (AU)

1















France (FR)

.407

1











Germany (GM)

.349

.667

1











J apan (J P)

.315

.392

.362

1









Netherlands (NL)

.444

.668

.738

.429

1







Switzerland (SW)

.421

.638

.687

.426

734 1





United Kingdom
(UK)

.489

.574

.475

.373

.653

.579

1



United States (US)

.508

.502

.473

.311

.620

.523

.542 1

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Domestic vs. International Diversification
27
12
P
o
r
t
f
o
l
i
o

R
i
s
k

(
%
)

Number of Stocks
1 10 20 30 40 50
U.S. stocks
International stocks
100
8
International Investing
The tools are Mean/Variance Analysis same as in previous
finance units.

However, there are many important cross-country differences that
matter when we invest internationally
Country Risk
Currency Risk

We start out with the mathematics of portfolio optimization


9
Portfolio Theory
Assumptions:
Nominal returns are normally distributed.
Investors want more return and less risk as denominated in
their home currency.
Let w
i
= proportion of wealth devoted to asset i such
that E
i
w
i
= 1
Expected return on a portfolio:

Portfolio Variance:

( ) ( )

=
i
i i P
R E w R E
( )

= =
i
ij j
j
i P P
w w R Var o o
2
where o
ij
=
ij
o
i
o
j
10
Expected Return on a Portfolio
E[R
i
]
i

A American 14.3% 16.4%
B British 17.6% 29.9%
J Japanese 17.7% 35.7%

Example: Equal weights (50%) of A and J:
E[Rp] = w
A
E[R
A
] + w
J
E[R
J
]
= (0.5x0.143)+(0.5x0.177)
= 0.16 or 16%
11
Portfolio Variance

Correlation
E[R
i
] o
i
A B J
A American 14.3% 16.4% 1 0.557 0.325
B British 17.6% 29.9% 0.557 1 0.317
J Japanese 17.7% 35.7% 0.325 0.317 1

Example: Equal weights of A and J
o
P
2
= w
A
2

o
A
2
+ w
J
2

o
J
2
+ 2 w
A
w
J

AJ
o
A
o
J

= (0.5)
2
(0.164)
2
+ (0.5)
2
(0.357)
2
+
2(0.5)(0.5)(0.325)(0.164)(0.357) = 0.0481
o
P
= (0.0481)
1/2
= 0.2190 or 21.9 percent
12
The risk of a portfolio is measured by the
ratio of the variance of a portfolios return
relative to the variance of the market return
(portfolio beta).
As an investor increases the number of
securities in a portfolio, the portfolios risk
declines rapidly at first, then asymptotically
approaches the level of systematic risk of
the market.

Diversification & Risk
13
The total risk of any portfolio is therefore
composed of systematic risk (the market)
and unsystematic risk (the individual
securities).
Increasing the number of securities in the
portfolio reduces the unsystematic risk
component leaving the systematic risk
component unchanged.
Diversification & Risk
14
Diversification & Risk
20
40
60
80
Number of stocks in portfolio
10 20 30 40 50 1
100
Percent
risk
=
Variance of portfolio return
Variance of market return
Portfolio of
US stocks
Total
risk
Systematic
risk
Total Risk = Diversifiable Risk + Market Risk
(unsystematic) (systematic)
By diversifying the portfolio, the variance of the portfolios return relative to the variance of the
markets return (beta) is reduced to the level of systematic risk -- the risk of the market itself.
15
Limitations of Domestic Investment
If we only invest in domestic shares, then we are limited
by the types of companies on offer in our home market.
For example, the Australian market is overweight in
mining companies and underweight in technology
companies compared to the US and other markets.
If we want to invest in IT or electronics companies, how
do we do that in Australia?
By investing internationally, we have a more diverse
range of investment opportunities.
16
Internationalizing a Domestic Portfolio
Domestic portfolio
opportunity set

o
DP

R
DP


Minimum risk (MR
DP
)
domestic portfolio
MR
DP

DP
Optimal domestic
portfolio (DP)
Expected Return
of Portfolio, R
p

Expected Risk
of Portfolio,
p

R
f

Capital Market
Line (Domestic)
An investor may choose a portfolio of assets enclosed by the Domestic portfolio opportunity set. The optimal domestic portfolio is found
at DP, where the Capital Market Line is tangent to the domestic portfolio opportunity set. The domestic portfolio with the minimum risk is
MR
DP
.
17
Internationalizing a Domestic Portfolio
R
f

CML (Domestic)

o
DP

R
DP

Domestic portfolio
opportunity set
DP
I nternationally diversified
portfolio opportunity set
R
IP


o
IP

IP
Expected Return
of Portfolio, R
p

Expected Risk
of Portfolio,
p

Optimal
international
portfolio
An investor may choose a portfolio of assets enclosed by the international portfolio opportunity set. The optimal international portfolio
is found at IP, where the Capital Market Line is tangent to the international portfolio opportunity set.
18
Domestic vs. International Diversification
27
12
P
o
r
t
f
o
l
i
o

R
i
s
k

(
%
)

Number of Stocks
1 10 20 30 40 50
U.S. stocks
International stocks
100
19
Key Results of Portfolio Theory
The extent to which risk is reduced by portfolio
diversification depends on the correlation of assets in
the portfolio.
As the number of assets increases, portfolio variance
becomes more dependent on the covariances (or
correlations) and less dependent on variances.
The risk of an asset when held in a large portfolio
depends on its return covariance (or correlation) with
other assets in the portfolio.
Example MSCI World Index & MSCI Emerging
Markets Index
20
Two Asset Case
21
Combinations of
the two portfolios
if correlation = 1
22
Combinations of
the two portfolios
if correlation = 1 Amount of
risk
reduction
23
24
Are Correlations Constant?
Longin & Solnik estimated national stock market
correlations during periods of high and low market
volatility assuming constant correlations (
i,us
) between
index i and the U.S. market.
While, movements in volatility of various market
indices are not synchronized, they nevertheless
conclude that volatility is contagious.
This means that stock markets tend to move together
during BAD times. Which is not good, as it is during
bad times that we really want differences across
markets.


25
The Bad News On Correlations
D
e

S
a
n
t
i
s

a
n
d

G
e
r
a
r
d

(
1
9
9
7
)

26
Exchange Rate Risk
The realized dollar return for an Australian resident
investing in a foreign market will depend not only on
the return in the foreign market but also on the change
in the exchange rate between the Australian dollar and
the foreign currency, i.e.
Uncertainty about what will happen to the foreign stock
market (r
foreign market
).
Uncertainty about what will happen to the exchange rate
(g
$/FC
).
27
The realized dollar return for an Australian
resident investing in a foreign market is given by:
1 ) 1 )( 1 (
$
+ + =
i i i
r R R
Where,
R
i
is the local currency return in the i
th
market.
r
i
is the rate of change in the exchange rate
between the local currency and the dollar.
Exchange Rate Risk
28
Exchange Rate Risk
An example with Japanese shares:
US investor takes $1,000,000 on 1/1/2002 and invests in
shares traded on the Tokyo Stock Exchange (TSE)
On 1/1/2002, the spot exchange rate was 130/$

The investor purchases 6,500 shares valued at 20,000 for a
total investment of 130,000,000

At the end of the year, the investor sells the shares at a price
of 25,000 per share yielding 162,500,000
On 1/1/2003, the spot exchange rate was 125/$

The investor receives a 30% return on investment
($1,300,000/$1,000,000) - 1 = 30%
29
Exchange Rate Risk
An example with Japanese shares:
The total return reflects not only the rise in the yen stock
price but also the appreciation of the yen.
The formula for the total return is:
( )( ) | | 1 r 1 r 1 R
shares, $/ $
+ + =
Where: [(1/125)/(1/ 130)]-1 = 0.04; [25,000/20,000]-1 = 0.25
( )( ) | | 30 . 0 1 25 . 0 1 04 . 0 1 R
$
= + + =
30
Exchange Rate Risk
The risk for an Australian resident investing in a foreign
market will depend not only on the risk in the foreign
market but also on the risk of the exchange rate between
the Australian dollar and the foreign currency:
) , Cov( 2 ) Var( ) Var( ) Var(
$ $ i i i i i
g R g R R + + =
This equation demonstrates that exchange rate fluctuations contribute to
the risk of foreign investment through two channels:
1. Its own volatility - Var(g
i
).
2. Its covariance with the local market returns - Cov(R
i
,g
i
).
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Country Index '07 Return
China SSEC 96.66%
India BSE 47.15%
Brazil Bovespa 43.65%
Hong Kong HSI 39.31%
South Korea Seoul Comp. 32.25%
Germany DAX 30 22.29%
Singapore ST Index 16.63%
Mexico IPC 11.68%
U.S. Nasdaq 9.81%
Canada TSE 7.16%
U.S. DJIA 6.43%
U.K. FTSE 100 3.80%
U.S. S&P 500 3.53%
France CAC 40 1.31%
Italy MIBTEL -7.81%
Japan Nikkei -11.13%
Where to Invest?
32
Where to Invest?
2006 returns
33
How to Invest?
Direct share investment purchase shares in foreign
markets using foreign currencies. Can be hard to do!
ADRs/GDRs purchase shares in foreign companies
that are traded on your home exchange in local
currency. Limited number!
MNCs why cant we just buy shares in multinational
companies to diversify internationally? Diversification
benefits not as good as investing internationally!
So what are the easy ways?

34
International Mutual Funds
An Australian investor can easily achieve international
diversification by investing in an Australian-based
international mutual fund.
The advantages include:
1. Savings on transaction and information costs.
2. Circumvention of legal and institutional barriers to direct
portfolio investments abroad.
3. Professional management and record keeping.
35
Country Funds
Recently, country funds have emerged as one of the most popular
means of international investment.
A country fund invests exclusively in the stocks of a single
country. This allows investors to:
1. Speculate in a single foreign market with minimum cost.
2. Construct their own personal international portfolios.
3. Diversify into emerging markets that might be inaccessible
to individual investors.
36
Other Avenues

Exchange Traded Funds ETFs are investment companies,
registered with the SEC with assets consisting of baskets of
securities included in an index fund.
One share in an ETF provides an investor diversification to all the
constituents of the relevant index and its price and yield track the
indices performance.
World Equity Benchmark Shares (WEBS)/iShares Country
specific baskets of stocks designed to replicate indices of 14
countries.
Low cost, convenient way for investors to hold diversified
investments in several different countries.
37
Home Bias Puzzle
Home bias refers to the extent to which portfolio
investments are concentrated in domestic equities.

Country

Share in World
Market Value

Proportion of Domestic
Equities in Portfolio

France

2.6%

64.4%

Germany

3.2%

75.4%

I taly

1.9%

91.0%

J apan

43.7%

86.7%

Spain

1.1%

94.2%

Sweden

0.8%

100.0%

United Kingdom

10.3%

78.5%

United States

36.4%

98.0%

Total

100.0%



38
Home Bias Puzzle Possible Explanations
Barriers to international investment (e.g. foreign investment not
allowed in a lot of countries).
restrictions on capital flows have fallen over time
can use country funds
International trading frictions: turnover taxes, other taxes, limited
liquidity
Not a huge problem for larger markets, yet home bias remains
Domestic equities may provide a superior inflation hedge.
Sovereign risk - repatriation of funds
Exchange rate risk
Information asymmetries
Psychological impediments
39
Conclusions
Low correlations across international markets may
increase the risk-return trade off

Important time variations may exist that can
challenge these benefits. Time horizon matters.

2
1
3
Investors might not be taking full advantage of the
benefits of international diversification. This is
known as the home bias puzzle.